F5 Networks’ fiscal 2019 first-quarter results were lukewarm, with the top line result in line with our estimate but below consensus expectations, and the bottom line superseding both our expectations as well as consensus. The confluence of incumbency within the application services space and cloud partnerships continue to allow the firm to remain relevant. As enterprises continue to evolve their IT infrastructures, customers find value in F5 software and services facilitating security and interoperability as they deploy workloads across different clouds and topologies. Management issued relatively conservative guidance, and though shares moved modestly lower after-hours, they remain at a premium relative to our unchanged $138 fair value estimate. We are also maintaining our narrow moat and negative trend ratings for this application services leader. While we think the firm can adapt its solutions and go-to-market strategies to defend its competitive position in the near to medium term, we continue to see secular headwinds longer term.
Total revenue of $543.8 million represented a 4% year-over-year increase. Revenue from products rose 3% with software, which accounted for 19% of product sales in the quarter, growing 21% and systems declining by less than 1% year over year. Management is targeting 30%-35% growth for software, implying an acceleration in the growth rate as we progress through the year. We view this as a lofty target even in the midst of a healthy IT spending environment and the firm’s advantageous short-term positioning, and anticipate that the company may fall marginally below the low end of this range for the full year.
The firm performed commendably on the margin front, with adjusted gross and operating margins widening by 50 and 100 basis points to 85.2% and 36.5% respectively. Efficiency automation within the service segment along with higher-margin software sales in the Product segment engendered the healthy margin expansion.
Business Strategy and Outlook
F5 Networks is a leader in the application delivery controller, or ADC, market, with 40% share. Its products have gained wide recognition among midsize and large organizations as well as service providers for the ability to manage and secure traffic transmitted along IP networks. Although it is entrenched, we think its core market will eventually shrink.
In short, F5's hardware and software appliances serve as an intelligent coordinator of network traffic between the outside world and internal data center. These products are quite complex. Because of their enterprise nature, F5 appliances are most commonly used by larger organizations operating with a significant web presence and myriad sites.
F5 has been extremely successful at expanding its ecosystem of products and organically expanding the ADC market. It has also consistently entered into adjacent markets through acquisitions, building up a portfolio of network traffic management and protection solutions that cohesively work with one another.
As a result of product complexities and architectural positioning at the forefront of the typical corporate data center, F5 products are very entrenched. With ever-expanding need for remote users to access internal corporate resources, added business requirements for online presence, and an increasing number of data streams flowing in and out of data centers, F5 products sit at the epicenter of traffic flow. Given the time and resources required to deploy and customize F5 installations with all the aforementioned traffic requirements in mind, these products are very sticky.
We view F5 as the strongest player in the ADC market, with its security and auxiliary application optimization products being main differentiators. The cloud-based players in this market can’t yet match F5’s sophisticated capabilities. But longer term, we think this will be a moot point as AWS and Azure ADC solutions mature. F5’s incremental functionality will either be co-opted by these vendors or reconfigured to align better with workloads native to the cloud. This poses a significant threat to F5's position, as these providers will be able to deliver similar capabilities for a fraction of the cost.
F5 Networks' product flexibility and complexity allow enterprises and service providers to deploy fully tolerant, secure, and highly customized solutions. Given the strategic position of F5's products in the corporate networks and complexity of deployment, along with a large body of knowledge available to support F5, IT managers will be highly reluctant to switch to a competing product. F5 has established itself as a leader in the mature application delivery controller field, with 50% market share and considerable brand strength. We consider F5's competitive advantages to be long lasting and assign the firm a narrow moat rating.
F5 Networks' ecosystem of products, the BIG-IP family, is based on its Traffic Management Operating System. BIG-IP is a highly configurable platform that allows various network traffic manipulation (iRules), event-based automation (iCall), and programmatic configuration (iControl). F5 has cultivated a strong community of network engineers and architects at its support platform, DevCentral, which also contains a large collection of prebuilt traffic scripts. Such a high level of flexibility allows enterprises and service providers to deploy a highly customized solution that governs the network traffic at the application level and below. F5 products are an essential part of multisite, web-facing networks. While the deployment of F5 products is not an easy task in the modern IT data center, given a spaghetti of third-party and in-house built apps making numerous inbound and outbound connections among sites and various service providers, we consider this a strategic advantage for F5. Customers are reluctant to embark on a competitive product switchover, owing to the highly disruptive nature and the time and resources required to get this task accomplished.
F5 was an early leader in network load balancing, which later evolved into the ADC marketplace. Over the course of years, the company has steadily incorporated in its platform a number of additional services and functionalities, such as web application firewall, SSL VPN, WAN optimization, threat detection, and DDoS prevention. The company is seen as a market leader and has developed a strong reputation, especially in light of Cisco's exit from this space. This strong competitive advantage allows F5 to charge premium pricing for its products and represents another moat source.
Fair Value and Profit Drivers
We are raising our fair value estimate for F5 Networks to $138 per share from $126, reflecting the time value of money and slightly stronger top line growth during our explicit forecast period. Our valuation implies an adjusted forward price/earnings multiple of approximately 15 times, enterprise value/adjusted EBITDA of 11.5 times, and free cash flow yield of nearly 6.5%. F5 is a narrow-moat stock with decelerating revenue growth, and it is seeking to expand its presence outside the core ADC market.
F5's revenue composition is shifting rapidly from products to services, with a revenue mix of 44% and 56%, respectively, in fiscal 2018. Approximately 98% of product revenue comes from the application delivery networking segment, with the remaining 2% coming from security. While the ADC market growth is projected to slow and security so far represents a tiny segment of F5 revenue, we expect the services segment to drive top-line growth during our explicit forecast period. Overall, F5 revenue should reach $2.3 billion by 2021, in our opinion.
F5's gross margin displayed healthy improvement over the past few years, expanding from 77% in 2008 to 83.3% in 2018. As IT workloads are increasingly shifting to the cloud, F5 is forced to compete with low-cost, cloud-native ADC solutions, and resultant pricing pressure should stymie margin expansion from increased software sales. We model gross margins widening slightly to 83.5% during our explicit forecast. Similarly, management navigated the company from a 16% operating margin in 2008 to an impressive 28% in 2016. Here too though, we expect the countervailing forces of leverage from software sales and heightened spending due to intense competition to facilitate a net result of relatively stable GAAP operating margins between 27% and 29%.
Overall, in the past five years, F5 has generated solid free cash flow. We expect this trend to continue, given the firm's strong market position and impressive profitability profile. The balance sheet remains healthy, and the company has been returning capital to the shareholders via share buybacks.
Risk and Uncertainty
With Cisco’s exit from the ADC market, F5 solidified its leadership position. While Citrix and Radware remain strong competitors, we do not foresee any drastic market share realignment among these players. The more important factor to consider is the tectonic shift in the industry, with the increasing stream of applications and workloads that are leaving the on-premises data center in favor of cloud computing. F5 offers a virtualized version of its BIG-IP platform for Amazon AWS and Microsoft Azure, which should help to alleviate short-term concerns. However, in the long run, we forecast Amazon and Microsoft cloud-based alternatives to F5's ADCs to be compelling to their customers.
Looking beyond the ongoing transition to the cloud, we expect an increasing number of applications written to run specifically in the cloud, using cloud-based resources and thereby limiting the need for complex traffic orchestration. This type of architectural shift will significantly undermine the need for F5 products.
Overall, we view F5 Networks' stewardship shareholder capital as standard. F5 Networks' success has been associated with longtime CEO John McAdam, who took over the company in 2000. During his tenure, F5 Networks' revenue grew from $108 million to almost $2 billion and the company was added to S&P 500. The company continuously expanded its market space and entered adjacent niches through organic growth and bolt-on acquisitions while successfully fighting its much larger competitors. In fact, the company became the de facto standard for the ADC market. McAdam retired in April 2017. New CEO Francois Locoh-Donou holds a bachelor of science and a master of science in physics and engineering, a master of science in optical communications, and an MBA from Stanford. He left the COO position at optical transport vendor Ciena, where he had been since 2002. We believe Locoh-Donou was the driving force behind Ciena’s Cyan acquisition and the overall push to increase the company’s focus on software solutions, which have become a focal point for many of Ciena’s clients. F5 and Ciena are targeting similar set of customers, which bodes well for Locoh-Donou.
The company has been steadily repurchasing shares while executing focused, tuck-in acquisitions to expand its business. The $2.4 billion stock-repurchase program initially approved in 2010 was supplemented by an additional $1 billion authorization in 2016. The recent acquisitions of Versafe ($87.7 million) and Defense.Net ($49.4 million) are intended to boost F5's efforts to carve out a niche in the security market.
F5 Networks provides products that govern traffic flows between on-premises applications and external users and services. In addition, the company provides numerous security solutions geared toward its existing user base. The company is a recognized market leader in application delivery controller equipment in the U.S. and around the world. The North American market represents approximately 50% of the company's revenue, EMEA 23%, and APAC 15%.